Question

You are trying to value “A2M” share today (End of June 2019). Assume the current price of the share in the stock market is $17.15 and that you would like to hold the investment for 4 years. Assume that “A2M” will pay its first dividend ($0.5 AUD) one year from now. The total dividend will be paid as a lump sum (at once). After this you also estimate that the dividends will grow respectively at 30%, 25% per year. After that (starting in time 3) you estimate dividends will grow at a constant rate of 5% forever. Assume that today the Australian treasury notes is 1.5%, the market risk premium is 10% and the beta of “A2M” is 0.8. Based on this price would you purchase the share? Why or why not? [9 marks]

Answer 1

We will find the cost of equity , to discount the dividend cash flows

With the given details, we can calculate cost of equity, ke, as per CAPM

ie.ke=Risk-free rate+(Beta*Market risk premium)

ie.1.5%+(0.8*10%)=

9.50%

Now, we can find the intrinsic value per share by discounting the dividend cash flows at the above cost of equity, 9.5%

we will find the yearly dividends & Value of the share at end yr.4 & discount those values at 9.5%, to know the stock's intrinsic value, P0, at time, t=0

Div.in Yr.	$ dividend amt.		PV F at 9.5%(1/1.095^yr.n)	PV at 9.5%
1	2	3	4	5=3*4
D1		0.5	0.91324	0.456621
D2	0.5*1.30=	0.65	0.83401	0.5421071
D3	0.65*1.25=	0.8125	0.76165	0.6188438
D4	0.8125*1.05=	0.85313	0.69557	0.5934118
P4=	0.85313*1.05/(9.5%-5%)=	19.90637	0.69557	13.846357
	Intrinsic value of this stock=sum of PV of dividend cash flows, at time, t=0			16.06

The current price of the share in the stock market is $17.15

whereas it's intrinsic value, when held for 4 yrs.= $ 16.06 , is less than the current purchase price

So, based on the above,it is NOT RECOMMENDED to buy,

given that the stock is to be held only for 4 years